CAP12PP2

Slide1: CHAPTER TWELVE Aggregate Demand in the Open Economy
Learning objectives: Learning objectives The Mundell-Fleming model: IS-LM for the small open economy Causes and effects of interest rate differentials Arguments for fixed vs. floating exchange rates The aggregate demand curve for the small open economy
The Mundell-Fleming Model: The Mundell-Fleming Model Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibrium---the IS* curve: where e = nominal exchange rate = foreign currency per unit of domestic currency
The IS* curve: Goods Market Eq’m: The IS* curve: Goods Market Eq’m The IS* curve is drawn for a given value of r*. Intuition for the slope:
The LM* curve: Money Market Eq’m: The LM* curve: Money Market Eq’m The LM* curve is drawn for a given value of r* is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e.
Equilibrium in the Mundell-Fleming model: Equilibrium in the Mundell-Fleming model equilibrium exchange rate equilibrium level of income
Floating & fixed exchange rates: Floating & fixed exchange rates In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. We now consider fiscal, monetary, and trade policy: first in a floating exchange rate system, then in a fixed exchange rate system.
Fiscal policy under floating exchange rates: Fiscal policy under floating exchange rates Y1 At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: e > 0, Y = 0
Lessons about fiscal policy: Lessons about fiscal policy In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out” closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.
Mon. policy under floating exchange rates: Mon. policy under floating exchange rates Y2 An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. Results: e < 0, Y > 0
Lessons about monetary policy: Lessons about monetary policy Monetary policy affects output by affecting one (or more) of the components of aggregate demand: closed economy: M  r  I  Y small open economy: M  e  NX  Y Expansionary mon. policy does not raise world aggregate demand, it shifts demand from foreign to domestic products. Thus, the increases in income and employment at home come at the expense of losses abroad.
Trade policy under floating exchange rates: Trade policy under floating exchange rates At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: e > 0, Y = 0
Lessons about trade policy: Lessons about trade policy Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade: the trade restriction reduces imports the exchange rate appreciation reduces exports Less trade means fewer ‘gains from trade.’ Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Worse yet, import restrictions create “sectoral shifts,” which cause frictional unemployment.
Fixed exchange rates: Fixed exchange rates Under a system of fixed exchange rates, the country’s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the context of the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate. This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.
Fiscal policy under fixed exchange rates: Fiscal policy under fixed exchange rates Y1 Under floating rates, a fiscal expansion would raise e. Results: e = 0, Y > 0 Y2 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under floating rates, fiscal policy ineffective at changing output. Under fixed rates, fiscal policy is very effective at changing output.
Mon. policy under fixed exchange rates: Mon. policy under fixed exchange rates An increase in M would shift LM* right and reduce e. To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. Results: e = 0, Y = 0 Under floating rates, monetary policy is very effective at changing output. Under fixed rates, monetary policy cannot be used to affect output.
Trade policy under fixed exchange rates: Trade policy under fixed exchange rates A restriction on imports puts upward pressure on e. Results: e = 0, Y > 0 Y2 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under floating rates, import restrictions do not affect Y or NX. Under fixed rates, import restrictions increase Y and NX. But, these gains come at the expense of other countries, as the policy merely shifts demand from foreign to domestic goods.
M-F: summary of policy effects: M-F: summary of policy effects
Interest-rate differentials: Interest-rate differentials Two reasons why r may differ from r* country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk. expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.
Differentials in the M-F model: Differentials in the M-F model where  is a risk premium. Substitute the expression for r into the IS* and LM* equations:
The effects of an increase in : The effects of an increase in  IS* shifts left, because    r  I LM* shifts right, because    r  (M/P )d, so Y must rise to restore money market eq’m. Results: e < 0, Y > 0 Y2
The effects of an increase in : The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation) is even greater than the fall in I (from the rise in r ). The effects of an increase in 
Why income might not rise: Why income might not rise The central bank may try to prevent the depreciation by reducing the money supply The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply) Consumers might respond to the increased risk by holding more money. Each of the above would shift LM* leftward.
CASE STUDY: The Mexican Peso Crisis: CASE STUDY: The Mexican Peso Crisis
CASE STUDY: The Mexican Peso Crisis: CASE STUDY: The Mexican Peso Crisis
The Peso Crisis didn’t just hurt Mexico: The Peso Crisis didn’t just hurt Mexico U.S. goods more expensive to Mexicans U.S. firms lost revenue Hundreds of bankruptcies along U.S.-Mex border Mexican assets worth less in dollars Affected retirement savings of millions of U.S. citizens
Understanding the crisis: Understanding the crisis In the early 1990s, Mexico was an attractive place for foreign investment. During 1994, political developments caused an increase in Mexico’s risk premium ( ): peasant uprising in Chiapas assassination of leading presidential candidate Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (So, r* > 0)
Understanding the crisis: Understanding the crisis These events put downward pressure on the peso. Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate. Doing this requires that Mexico’s central bank have adequate reserves of dollars. Did it?
Dollar reserves of Mexico’s central bank: Dollar reserves of Mexico’s central bank December 1993 ……………… $28 billion August 17, 1994 ……………… $17 billion December 1, 1994 …………… $ 9 billion December 15, 1994 ………… $ 7 billion During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.
 the disaster  :  the disaster  Dec. 20: Mexico devalues the peso by 13% (fixes e at 25 cents instead of 29 cents) Investors are shocked ! ! ! …and realize the central bank must be running out of reserves… , Investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets e float. In a week, e falls another 30%.
The rescue package: The rescue package 1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt. This helped restore confidence in Mexico, reduced the risk premium. After a hard recession in 1995, Mexico began a strong recovery from the crisis.
The S.E. Asian Crisis: The S.E. Asian Crisis
Floating vs. Fixed Exchange Rates: Floating vs. Fixed Exchange Rates Argument for floating rates: allows monetary policy to be used to pursue other goals (stable growth, low inflation) Arguments for fixed rates: avoids uncertainty and volatility, making international transactions easier disciplines monetary policy to prevent excessive money growth & hyperinflation
Mundell-Fleming and the AD curve : Mundell-Fleming and the AD curve So far in M-F model, P has been fixed. Next: to derive the AD curve, consider the impact of a change in P in the M-F model. We now write the M-F equations as: (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)
Deriving the AD curve: Y1 Y2 Deriving the AD curve AD Y2 Y1 Why AD curve has negative slope: P  LM shifts left    NX  Y  (M/P )
From the short run to the long run: From the short run to the long run then there is downward pressure on prices. Over time, P will move down, causing (M/P )   NX  Y 
Large: between small and closed: Large: between small and closed Many countries - including the U.S. - are neither closed nor small open economies. A large open economy is in between the polar cases of closed & small open. Consider a monetary expansion: Like in a closed economy, M > 0  r  I (though not as much) Like in a small open economy, M > 0    NX (though not as much)
Chapter summary: Chapter summary 1. Mundell-Fleming model the IS-LM model for a small open economy. takes P as given can show how policies and shocks affect income and the exchange rate 2. Fiscal policy affects income under fixed exchange rates, but not under floating exchange rates.
Chapter summary: Chapter summary 3. Monetary policy affects income under floating exchange rates. Under fixed exchange rates, monetary policy is not available to affect output. 4. Interest rate differentials exist if investors require a risk premium to hold a country’s assets. An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate.
Chapter summary: Chapter summary 5. Fixed vs. floating exchange rates Under floating rates, monetary policy is available for can purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions.

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